The Internal Revenue Service has announced a settlement program for taxpayers who participated in abusive programs. Captive insurance is making headlines. Federal regulators have been investigating these arrangements. They claim that some taxpayers incorrectly claimed tax benefits, without properly setting up a bonafide captive-insurance program. Captive insurance arrangements can provide valuable tax benefits if they are properly established for insurance purposes.
What is captive insurance?
Captive insurance is a process that allows a company to create its own insurance company to address known risks. A physician’s group may create a captive program to address specific risks within their practice and their profession.
Micro-captives, also known as 831 (b) captives, offer small businesses tax benefits. The premiums paid to an 831 (b) captive agreement by a business are deductible as business expenses. If the premium is less than $2.3 million per year, they are not considered income by the captive insurance company. You should note that investment gains made with funds within the captive may be subject to taxation.
The arrangement must be able to provide insurance, as the captive is an insurance entity that has been legally registered at the state level. The business must verify that there is risk and demonstrate a method for sharing and distributing risk.
One of the many advantages is customization
Captive insurance gives businesses the ability to tailor their insurance coverage to meet specific requirements. The insurance’s underwriting is based upon the business’s risk profile.
Other benefits include:
- This insurance policy covers uninsured risks that are not available or cost-effective on the commercial insurance market.
- May be able to access the reinsurance marketplace, which may prove to be a cost-effective way of securing coverage
- This can be used as an asset protection strategy. The business owner’s potential creditors are unlikely to sue funds held in the separate captive insurance company.
- Can be used to accumulate wealth and for transfer. Captive insurance funds can accumulate over time and be a financial asset for the business or practice, subject to claims history. The owners of captive insurance might be able to receive dividend payments as a way to generate cash flow. A trust or family limited partnership (FLP) can allow the owners to transfer ownership of a captive company to their heirs.
What are the benefits of captive insurance plans?
- Businesses with high-deductible insurance policies are eligible for a deduction reimbursement
- Risk shifting involves raising the deductible limit on existing coverage (such malpractice insurance) and using cost savings to finance the captive.
- A commercial general liability policy may exclude product liability.
- Employment-related claims and risk
- Cyber risks, such as data breaches
- Environment risks
- Litigation expense risk
- Business interruption
Common situations that could become problems
There are many common situations that could lead to IRS scrutiny and an audit. Here are some examples:
- If the risk being covered against is unclear or poorly defined
- If the premiums that are used to fund the captive are very high in relation to the risk level,
- If the claims history has been very poor. If the claims history is very poor.
- Inadequate planning and analysis. There was no formal feasibility study done during the establishment of the captive.
Captive insurance may pose its own risk
The establishment of a captive insurance company comes with its own risks. It can be costly and complex. This strategy can be implemented best by a qualified lawyer with relevant experience.